Is Hovnanian Enterprises Heading For a Slowdown?

Here at The Motley Fool, I've long cautioned investors to keep a close eye on inventory levels. It's a part of my standard diligence when searching for the market's best stocks. I think a quarterly checkup can help you spot potential problems. For many companies, products that sit on the shelves too long can become big trouble. Stale inventory may be sold for lower prices, hurting profitability. In extreme cases, it may be written off completely and sent to the shredder.

Basic guidelines In this series, I examine inventory using a simple rule of thumb: Inventory increases ought to roughly parallel revenue increases. If inventory bloats more quickly than sales grow, this might be a sign that expected sales haven't materialized. Is the current inventory situation at Hovnanian Enterprises (NYSE: HOV) out of line? To figure that out, start by comparing the company's inventory growth to sales growth. How is Hovnanian Enterprises doing by this quick checkup? At first glance, pretty well. Trailing-12-month revenue increased 30.9%, and inventory increased 1.4%. Comparing the latest quarter to the prior-year quarter, the story looks decent. Revenue increased 42.7%, and inventory expanded 1.4%. Over the sequential quarterly period, the trend looks healthy. Revenue grew 26.1%, and inventory dropped 2.2%.

Advanced inventory I don't stop my checkup there, because the type of inventory can matter even more than the overall quantity. There's even one type of inventory bulge we sometimes like to see. You can check for it by examining the quarterly filings to evaluate the different kinds of inventory: raw materials, work-in-progress inventory, and finished goods. (Some companies report the first two types as a single category.)

A company ramping up for increased demand may increase raw materials and work-in-progress inventory at a faster rate when it expects robust future growth. As such, we might consider oversized growth in those categories to offer a clue to a brighter future, and a clue that most other investors will miss. We call it "positive inventory divergence."

On the other hand, if we see a big increase in finished goods, that often means product isn't moving as well as expected, and it's time to hunker down with the filings and conference calls to find out why.

What's going on with the inventory at Hovnanian Enterprises? I chart the details below for both quarterly and 12-month periods. (Hovnanian Enterprises reports raw materials and work-in-progress inventory combined.)

Let's dig into the inventory specifics. On a trailing-12-month basis, each segment of inventory decreased. On a sequential-quarter basis, raw materials inventory was the fastest-growing segment, up 2.6%. Hovnanian Enterprises seems to be handling inventory well enough, but the individual segments don't provide a clear signal.

Foolish bottom line When you're doing your research, remember that aggregate numbers such as inventory balances often mask situations that are more complex than they appear. Even the detailed numbers don't give us the final word. When in doubt, listen to the conference call, or contact investor relations. What at first looks like a problem may actually signal a stock that will provide great returns. And what might look hunky-dory at first glance could actually be warning you to cut your losses before the rest of the Street wises up.

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Seth Jayson had no position in any company mentioned here at the time of publication. You can view his stock holdings here. He is co-advisor ofMotley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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